The Balassa-Samuelson and the Penn Effect: Are They Really the Same?

According to the Balassa-Samuelson effect, productivity gains in the domestic tradable sector raise the relative price of domestic non-tradables causing deviations from the purchasing power parity. In the literature, the Balassa-Samuelson effect is typically invoked to explain the Penn effect, according to which the price level is higher in richer countries, so that their real income is overstated if converted at market exchange rates. In this paper, using a two-country, two-sector international real business cycle model, which closely follows Stockman and Tesar (1995) and Benigno and Thoenissen (2008), we show that the Balassa-Samuelson effect only explains the Penn effect either for a sufficiently high trade elasticity or for a low degree of home bias; if asset markets are incomplete, furthermore, it does so also in the presence of high complementarity between tradables and non-tradables or for a low share of tradables in consumption. These results are coherent with the empirical evidence, which generally supports the prediction of the Balassa-Samuelson model about relative price of non-tradables but is more controversial about real exchange rate appreciation in response to productivity gains in tradables.